Eli Kammerman Joe E. Kiani - Founder, Chairman and Chief Executive Officer Mark P.

de Raad - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Corporate Secretary

William R. Quirk - Piper Jaffray Companies, Research Division Brian Weinstein - William Blair & Company L.L.C., Research Division Chris Lewis - Roth Capital Partners, LLC, Research Division Konstantin Tcherepachenets

Hello, everyone. Joining me today are Chairman and CEO, Joe Kiani; and Executive Vice President of Finance and CFO, Mark de Raad.

This call will contain forward-looking statements, which reflect Masimo's current judgment. However, they are subject to risks and uncertainties that could cause actual results to differ materially.

Risk factors that could cause our actual results to differ materially from our projections and forecasts are discussed in detail in our SEC filings, including our most recent Form 10-K and Form 10-Q. You will find these in the Investors section of our website.

I'll now pass the call to Joe Kiani.

Thank you, Eli. And thank you for joining us today to review our third quarter results.

We're happy to report that we achieved double-digit sales growth once again. Our shipments of Pulse Oximetries and Pulse CO-Oximetries, excluding handheld devices in the third quarter were very strong, and in fact, set a new quarterly record, rising 33% to 44,000 units.

In turn, our global installed base rose to 1,180,000, up 12% over the past year, significantly exceeding market growth. Importantly, despite the traditionally slower third quarter period, we still saw a sequential increase in rainbow revenues over the second quarter 2013.

Building off this momentum, we do expect to see a strong end of the year in our rainbow revenue, and as a result, continue to believe we can achieve our original target of $50 million in 2013 rainbow revenues. Lastly, our business model yielded increased earnings leverage with a year-over-year earnings per share growth of 13%.

I'm also optimistic that our investments in new product development will set us up for an exciting 2014. I'll highlight some key accomplishments from the quarter and provide an operational overview in a few minutes.

But first, Mark will provide some additional details on our third quarter financial performance. Mark?

Thank you, Joe, and hello, everybody. Third quarter 2013 total revenue, including royalties, was $131.4 million, up 10% or 12% on a constant currency basis versus the third quarter of 2012.

Product revenue was $124.5 million, up 11%, or 13% on a constant currency basis versus the third quarter of 2012. The significant year-over-year negative impact of foreign exchange movements was due almost entirely to the weakening of the yen versus the U.S.

dollar, which reduced third quarter 2013 product revenue by $1.8 million versus the year-ago quarter, and in fact, $4.8 million for the entire year. Rainbow product revenue grew 9% in the third quarter to $12 million, due primarily to higher instrument and board revenues as we continue to see the impact of increased OEM rainbow adoption.

In addition, continuing the trend for most of fiscal 2013, approximately half of our 20 -- half of our Q3 2013 total rainbow revenues were consumables. In a few moments, Joe will provide some additional information on our Q3 2013 SpHb revenues.

Our worldwide end-user or direct business, which includes sales through just-in-time distributors grew 12% in the third quarter to $106.4 million versus $95.2 million in the year-ago period. Our direct business represented 85% of total product revenue in the quarter, consistent with 85% 1 year ago.

OEM sales, which made up the remaining 15%, rose 7% to $18.1 million compared to $16.9 million in the same period of 2012. By geography, total U.S.

product revenue rose 11% to $88.2 million, compared to $79.2 million in the same quarter of 2012. Growth was driven primarily by increased SET Pulse Oximetry center sales to hospital customers, resulting from the strong shipments of drivers this year.

International product revenue rose 10% or 16% on a current -- constant currency basis to $36.3 million in the third quarter of 2013 versus $32.9 million in the same period last year. This increase is primarily due to growth in our EMEA business.

International revenue represented approximately 29% of total product revenue in the third quarter of 2013, which was level with 1 year ago. Our third quarter product gross profit margin was 64.7% compared to 63.7% 1 year ago.

In fact, had it not been for the unfavorable movements in year-over-year foreign exchange rates, our pro forma gross profit margin would've been 65.2%. As we anticipated earlier in the year, the year-over-year gross profit margin improvement is due primarily to our ongoing manufacturing product and production cost reduction efforts.

Our third quarter total gross profit margin, including royalties was 66.6%, up 80 basis points versus the year-ago period, as royalty payments comprised a smaller portion of total revenues than in the year-ago period. Third quarter 2013 operating expenses were $66.7 million, which was up 11% versus the year-ago quarter.

Contributing to this increase was $1.6 million in new fiscal 2013 medical device excise taxes. Without the impact of this additional medical device tax, our operating expenses rose by 8%.

SG&A expenses increased 10% versus the year-ago period to $53.1 million. Again, excluding the $1.6 million in medical device excise tax, our SG&A expenses rose 7% from $48.3 million to $51.5 million.

This increase was due primarily to higher year-over-year staffing levels related primarily to our new worldwide blood management sales team, higher legal fees and various marketing-related expenses. R&D spending rose 13% to $13.6 million in the third quarter, compared to $12.1 million in the year-ago period, due to increased staffing levels, engineering product and project and new product development related costs.

Third quarter 2013 operating income was therefore $20.7 million, up 16% compared to $17.9 million in the year-ago period. Nonoperating expense was about $700,000 in the third quarter due primarily to the net unfavorable effect of changes in the value of the U.S.

dollar versus the Swedish krona and the euro. This compares with nonoperating income of approximately $900,000 in the year-ago period, which was primarily attributable to the favorable effect of changes in the value of the U.S.

dollar versus the Japanese yen and the euro. Our third quarter 2013 effective tax rate was 22.8%, down from 28.1% in the same period last year.

This decline from our expected 28% annual effective tax rate was due primarily to the conclusion of a prior year tax audit. Third quarter 2013 net income was $15.6 million or $0.27 per diluted share, compared to $13.8 million or $0.24 per diluted share the same prior year period.

Importantly, the current third quarter results were reduced by approximately 2% due to the impact of the new medical device tax, which became effective in January 2013. As of September 28, 2013, our days sales outstanding was 51 compared to 49 as of the end of December 2012.

Over the same period, inventory turns declined to 3 from 3.8 due to our commitment to retain higher levels of inventory in order to better serve our customers. Total cash and cash equivalents as of September 28, 2013, were $91.7 million compared to $71.6 million as of December 29, 2012.

The change reflects net cash generated from operations offset by capital expenditures and $19.8 million in share repurchases during the first half of the year. Incidentally, we did not repurchase any shares in the third quarter and have repurchased a total of 1 million shares year-to-date.

To conclude the financial remarks, I wanted to make just a quick comment on the upward revision to our 2013's earnings guidance per share that we made in our press release today. Encouragingly, despite the cumulative negative $0.04 impact of foreign exchange movements on our EPS for the first 9 months of this year, and that would be compared to our original 2013 foreign exchange rate assumptions, we are increasing our annual earnings per share financial guidance from $1.14 to $1.16 per share.

While we believe that our initial 2013 annual financial guidance ranges for product revenues, rainbow revenues, product gross profit margins, operating expenses and tax rates are still appropriate, our favorable year-to-date financial results, combined with our slightly more favorable outlook for fiscal Q4, are the factors allowing us to increase our EPS guidance for 2013. Now I'll turn the call back to Joe.

Thank you, Mark. Our third quarter 2013 results reflected the compelling clinical value of our breakthrough Signal Extraction Technology and rainbow SET technologies and the robust strength of our innovation-driven and recurring revenue business model.

This combination positions Masimo for solid product revenue growth well into the future. In addition, we believe we are now beginning to see some of the leverage in the business model and it's the result of a combination of the development of exciting new technologies, the continued expansion of our product portfolio and improvements in our operational efficiency.

We again realized market share gains that are visible in our new driver shipments and in our sales performance, reflecting the effectiveness of our technology and value proposition. The 33% year-over-year increase in drivers is attributable to consistently winning new pulse oximetry agreements with hospitals that include installations into their general wards.

In Q3, we are proud to have entered into many new hospital agreements, including St. Joseph Health, a 14 hospital -- 4,000-bed healthcare system based in California, Texas and Eastern New Mexico.

A hospital system that many of us rely upon locally. Another encouraging sign is that the level of our renewal business is expanding, as our existing customers see the benefits of our monitoring solutions for both patient safety and for lowering overall cost of care.

With rainbow SET, clinicians get a host of unique breakthrough measurements, such as our rainbow Acoustic Monitoring respiratory measurement, which has been shown in multiple independent studies to help clinicians improve patient care, save lives and reduce costs. Rainbow SpHb noninvasive hemoglobin has been shown to help reduce blood transfusion rates and associated cost and mortality.

In the third quarter of 2013, total hemoglobin sales were $3.9 million, up versus Q2, despite the usual seasonality in our overall Q3 product sales. We have now hired 49 worldwide blood management sales reps and clinical specialists toward our goal of 60.

Our OEM partners, such as Dräger which offer rainbow-equipped monitors continue to help increase the adoption of rainbow through building awareness. We continue to expect the 2 largest companies in the global patient monitoring market, Philips and GE Healthcare, to introduce our initial rainbow products during 2014.

We continue to believe that these new OEM introductions will increase visibility and demand for rainbow parameters, and in so doing, open up new channels for Masimo Rainbow sensors. We continue to believe that sales of rainbow in 2013 can meet our expectations of reaching $50 million.

We currently have rainbow orders, which if all shipped this year, would enable us to meet this target. These orders include an unexpected product mix.

If our production capabilities cannot fulfill this unexpected product mix in 2013, then we fully expect to ship the remaining quantities in 2014. Our new breakthrough open architecture monitor and connectivity platform named ROOT has been well received.

ROOT is capturing attention as a versatile, user-friendly information hub. While providing the full suite of Masimo parameters, ROOT is also designed to integrate unlimited new applications for the operating room and general floor with the Masimo Open Connect technology called MOC-9.

For example, ROOT can incorporate our previously separate brain function monitor SEDLine via MOC-9 as a sample plug-in technology in the cable solution that transmits data to the ROOT display screen. The ability of ROOT to accept new functionalities from third-party developers increases its utility to customers and provides an avenue to commercialization for MedTech innovators.

We've begun the premarket release of ROOT in many countries, with abilities to integrate SEDLine brain function monitoring, ASA capnography and, of course, our radical rainbow SET Pulse CO-Oximetry and rainbow Acoustic Monitoring. ROOT with Wi-Fi and IRIS data communication capabilities is still pending FDA clearance.

In addition to ROOT, although I can't make any new announcements yet, our new product development pipeline is robust and includes additional breakthrough technologies, as well as innovative new form factors for our current measurement capabilities. With our guiding principles, including the guiding principle to always do what is best for patient care, our portfolio of advanced monitoring technology positions us as the clear leader for improving medicine and will continue to propel Masimo's steady and fast growth.

With that, we'll open the call to questions. Operator?

So I guess, first, Joe, I was hoping you could elaborate a little bit on the $50 million rainbow targets. It sounds like -- if I heard you correctly, it sounds like we have some pretty good size orders coming here already in the fourth quarter.

But then, can you perhaps elaborate on your comments regarding production capacity? I guess a different way of asking the question is, where are you today in terms of capacity to handle rainbow?

And then just perhaps layer that over with the -- with my earlier question.

Certainly. Yes, it's not really about capacity.

It's lack of capacity -- constraint capacity of shipping what we did not expect in the rainbow order. In one of our large rainbow orders this quarter that ideally the customer wants shipped this quarter, we have gotten a very large order for disposable carbon monoxide sensors.

Typically, our customers use reusable carbon monoxide sensors which, of course, includes Pulse Oximetry as well. So because we weren't anticipating it in a disposal format, in such an order, we are doing our best to make the necessary adjustments and orders with our vendors and suppliers to be able to fulfill this order.

As I said, if we can't fulfill all of it in 2013, obviously, the order is still good and we'll fulfill the rest in 2014.

Okay, but just to be clear, Joe. So assuming that, let's say, hypothetically, the order had come in as reusable sensors which is, obviously, we're used to producing for carbon monoxide.

I -- it's my understanding or my interpretation of your comments is that you would be very comfortable with that $50 million for the quarter, excuse me, for the year, is that correct?

Yes, yes. But also, given that we're trying to not disappoint, we have other avenues to still get to our $50 million even if we cannot ship this entire order.

So as long as -- even if the entire order is shippable or even if not, other orders that we anticipate come in, we still feel good about this $50 million number and which is why we are reiterating it and not shying away from it, given that we are where we are right now.

Okay, very good. And then just a real quick one for me, I guess, as a follow-up.

Is anything new on Pronto, Joe? We had some decent checks at a couple of conferences on that product?

In what sense are you asking is there anything new on Pronto?

Well, just could you elaborate us on how that business is tracking.

Sure, sure. As you know, Pronto and Pronto-7, we've finally felt good enough about it, and the reimbursement dynamics out there, to bring on distributors.

So now we're really working through distributors. We have Henry Schein and we have PSS which has been acquired by McKesson.

And we had a very good quarter with Henry Schein, and feel like the strategy is still a good one to work through the distributors.

So other companies that we cover that are involved in the blood management space in our field checks have really indicated there has been a significant acceleration in hospitals focusing on patient blood management, results have shown that -- and certainly results have shown that as well that came out from the AABB. So I'm curious about what you're seeing on the patient blood management side and I would've thought that we would've seen potentially some acceleration in your hemoglobin product as a result of those dynamics.

So can you comment on just kind of when you would typically expect to see an acceleration as a result of those trends?

Sure. Sure.

You are right. Blood management has become a focus for many hospitals as they're recognizing that it's not only one of the top 5 expenses of hospital for buying and providing blood to patients but also blood transfusion has, at least, there's been a correlation to suggest that blood transfusion can reduce -- well, increase mortality and increase morbidity.

And therefore, there's a lot of attention of what to do to minimize blood transfusion. Having that study showing that it's all over the place, not only at different institutions, but even in a given hospital that -- and the tendency is to give more than is needed, but of course, sometimes giving it later than it's needed.

So having a device that's a continuous way of measuring hemoglobin, that's an indicator of when you need blood transfusion, and 2 randomized controlled trials now showing that, in fact, it does reduce blood transfusion by 90% from the Mass General study in orthopedic patients, which are less bloody of procedures, and by 50%, in the neuro patients from Cairo University study, which is a high blood loss situation, we feel that we have something great to offer for patient care and for reducing cost. So to go back to your question of are we seeing momentum build?

The answer is, yes. For example, just this last quarter, UCLA became one of the new better care customers where they're taking advantage of our guarantee, the blood transfusion related cost reduction guarantee, and 2 other hospitals have already begun that guarantee.

They're about 7 to 9 weeks into it, and -- but as you know, we don't recognize the revenue from those sales until the guarantee period is over so that we don't get into a situation where, God forbid, we have to back something out. So we're confident that we're on the right track.

We're confident that hemoglobin -- noninvasive hemoglobin is a lifesaver and a cost reducer. And I think, the feedback I'm getting from the sales leadership that momentum is building.

How long is that period until you can recognize the revenue? Is it a 1 year type of situation?

Or is it longer than that?

It depends on the customer. Some customers are as short as 3 months, some 1 year.

And not every customer is taking advantage of Better Care literally through the guarantee. We have a couple of customers that, given the guarantee and they saw the confidence we had, they just went ahead and began placing it and using it.

So, obviously, we're recognizing those revenues, and that's why you see the sequential growth despite Q3 being generally a down for every other thing we do.

First, another really strong quarter and driver shipments this quarter, this being the largest but the past 4 have also been strong. Joe, I was just hoping you can elaborate a bit on what is driving that increased level of placements that seems both on the customer renewal side, along with new customer wins.

So I was just hoping you could elaborate on that.

Well, I really believe -- and trust me, we ask ourselves the same questions because it is definitely picking up. I believe, really, it's a combination of things.

I don't think it's one thing. Certainly, the value proposition of SET Pulse Oximetry is not even questionable.

There are over 100 studies that prove that SET reduces waste in sensors, reduces false alarms which is a big issue for consumers these days and helps treat things like retinopathy of prematurity, to make sure it doesn't happen, detects CCHD and so forth. But I also think, 1 of the things that's driving it is its strength on the general floor.

The general floor is a place where patients are active, so false alarms during motion is even a bigger issue, and you can't afford to have your nurses rush back and forth into the bedside every 4 minutes. So I think as people begin seriously looking at doing continuous monitoring of their patients post surgically, they begin to really see the advantages of Masimo SET, as well as the Patient SafetyNet system we've developed which then, obviously, says well if it's good enough for our patients on the general floor, why would we not want to use it in the rest of the hospital.

And in addition, I think rainbow has been a contributor. The innovation that we have brought forward, certainly in patient monitoring industry is unprecedented.

If you go to a trade show that we go to, I think you'll see we're kind of like the bright shining city in the middle of it all. So I think a lot of hard work is finally paying off, and we foresee the drivers to continue at that level certainly in Q4 and hopefully beyond.

Great. And as a follow-up to that, how does that translate into accelerated sensor sales from that increased level of drivers being placed going forward?

Well, clearly, they're correlated and that's why we feel good about the solid growth ahead of us. I think some of the -- we would see even greater growth had it not been for some of the FX issues that Mark spoke about, as well as some of the recycling that goes on of our sensors that are not right both for IP perspective as well as for consumers.

These recycled sensors that some companies are selling, all of them, none of them meet the specifications of Masimo. In fact, they don't even pretend to meet it, yet somehow, I guess, through the hospital and we feel like it's impact has grown in the years.

We're hoping that through X-Cal and through clinicians noticing that when they buy recycled sensors, their actual sensor volume increases because they don't work right, we'll see a reversal of that. But to answer your question more directly, we definitely are going to see the growth of our pulse ox to be correlated to the drivers we put.

But also, I think as we do a better job of educating our customers on the issue of the recycled sensors and maybe even the FDA of how problematic these sensors are, maybe we'll see a nice bump on top of the normal growth you would expect.

This is actually Konstantin for Larry. So a couple of questions.

First, I guess -- I suspect you guys are not going to provide 2014 guidance, but maybe, if you could just at a high-level just help us think of -- through some of the puts and takes for 2014 in terms of kind of revenue and the rest of the P&L.

Konstantin, this is Mark. I think just to be fair, I don't think we're really in a position to begin categorizing our outlook to 2014 yet.

I think what you've heard here today is a very positive and enthusiastic outlook to Q4. Typically, we do let the Q4 period complete before we start assessing what we think the overall impact on that quarter for 2014 will be.

So we'll plan to get into that type of detail, as we usually do in our February call.

Understood. And Joe, maybe can you just provide some comments regarding your latest thoughts on M&A?

I think at the time of last quarter's call, I think there was some stuff you guys were working on. So can you maybe provide some update?

Sure, Konstantin. We don't have anything at our sites to do something right away with, but we are watching several companies in our radar screen and going through the usual dance, but also due diligence as part of that dance.

But none of these are acquisitions that are a huge revenue opportunity, but rather technology tuck-ins and things that we think are either synergistic in our business model or new opportunities that may, in the future, with some of the future projects we're considering create the right vehicle to kind of be in that space. So nothing imminent, but we're examining everything, and Eli Kammerman, who's here with us, is a big part of that effort.

Terrific. And just if you can also maybe provide us any kind of update on the litigation against Philips?

Yes. Well, actually, we were very excited that December 2, we get to meet our judge for the first time after, my god, nearly 5 years since we filed this lawsuit.

We hear he's a great judge, and we're hoping to get the litigation completed as soon as possible. Philips is a good partner of ours.

It's a shame we have to resolve this in such a property matter in the courts since we could not do it on our own. But the sooner we get that behind us, both for the relationship and from the perspective of expenses, the better.

I'm wondering if you can provide some color on the significant increase in prepaid expenses in the quarter. They were up to $19 million from $13 million in the prior quarter?

And also, discuss a little bit more about receivables, which you alluded to before.

Sure. On the receivable question, really, no major issues or concerns there.

Typically, our third quarter of every year is the quarter in which we see a slightly higher level, simply because of the dynamics of how revenue flows in the third quarter, which essentially means that we see lower activity in July and August and then a big spike in September. So the ability to convert those receivables into cash is more limited in the third quarter than it is in other quarters.

The other issue on the prepaid simply has to do with some of our deferred tax asset movements on the balance sheet, as well as a couple of other prepaids related to various property and equipment investments that we're making, that have not yet quite moved to the stage where they would be recorded in capital equipment.

So is it possible to quantify the benefit that, that had on operating expenses in the quarter?

Sorry, the benefit of what?

Of deferring paying those expenses.

No, these are capital.

Everything is capital expense?

Yes. It's a classification on the balance sheet.

And inventories were up significantly in the quarter also. Can you touch upon that?

Sure. I think, as we said in our prepared comments, we intentionally at the start of this year made a commitment to raise the level of our inventory levels, primarily because in the first quarter, we had such a demand that we actually got into a situation where we were uncomfortable in the amount of inventory that we had on hand to meet that demand.

So we made a conscious effort to allow inventories to rise over the following couple of quarters, which as you point out, they have. Having said that, I'd still think that the before the end of year, that number -- my guess would be that number will be somewhere between $3 million and $3.5 million when we close out the year.

Operator, are there any other questions?

Okay, if there are no additional questions, then we'll end this call. I want to thank you all for joining us today, and wish you a happy trick and treat.

Bye.